Bilateral trade flows and income-distribution similarity

This paper accounts for non-homothetic preferences by specifically investigating the role of income per capita and income-distribution differences in the context of the gravity model of trade. A theoretically justified gravity model is estimated for disaggregated trade data using a sample of 104 exporters and 108 importers for 1980-2003 to achieve two main goals. First we are able to empirically test some of the theoretical predictions of Markusen (2010), namely that there is a positive dependence of trade on per capita income and that higher inequality increase trade of more sophisticated goods. Second, and in line with the Linder hypothesis, we hypothesized that a higher demands´ overlap implies a more similar demand structure and therefore more trade. We test this hypothesis with new measures of income-distribution similarity. National income distributions are used to calculate income similarity indices that measure how much each country pair overlaps in terms of income distribution and population. We find that per capita income is positively related to bilateral trade and that on average, a 10 percent increase in incomedistribution similarities increases exports by almost 4 percent being this effect stronger for more sophisticated goods in comparison with more homogenous ones.